The Stock-Picking Process
Most of our Insights expand on topics that are relevant to our companies, but this one will focus on another important topic: the stock-picking process. We will discuss the motivations for picking stocks, some examples of angles of attack, and how Recurve's process works.
Why Pick Stocks?
We agree with Warren Buffett's view that most everyday people shouldn't try to pick stocks on their own unless they are willing to dedicate significant time and resources to the effort. Instead, they should invest the majority of their equity exposure into low-cost index fund products. Owning a piece of American businesses via domestic index ownership is a great way to ensure solid long-term performance.
Those who pick stocks do so for one simple reason: to beat the market. At a high level, it sounds simple and reasonable. Can't we filter OUT some of the worst companies in the indices? Can't we simply own the best companies?
Unfortunately, investing is not so simple and there is no free lunch - the market usually forces us to accept at least one area of discomfort. The worst companies often trade at low valuations which incorporate significant fear. The best companies usually incorporate significant optimism in their valuations. Would you prefer to own a lower-quality company trading at a low valuation, or a higher-quality business that is expensive? How would you behave if the lower-quality business worsened and the stock dropped 50%, but was still cheap? What about if the higher-quality company performed well but slightly below expectations, and its premium valuation fell significantly, also resulting in a 50% drawdown, but it was still expensive? We rarely get the opportunity to own great companies at cheap valuations. When we do, there is probably a crisis occurring in the broader market (e.g. Covid in March 2020) or a transitory period where the long-term quality of the company is drawn into question (e.g. Meta in late 2022).
What unfolds in the future, relative to embedded expectations, will dictate future performance. The longer our investment horizon, the more likely it is that performance will roughly equate to growth in free cash flow per share. A lot of other factors seem important in the short term (economic cycle, geopolitical events, etc.), but their impacts diminish relative to growth in free cash flow per share as we extend the horizon. Ultimately, the approach should simplify to owning companies that you’d want to own privately on a long-term basis, through all the twists and turns of the global economy.
Read on for some insights into the challenging and ever-fascinating stock-picking process for long-term investors.
The Idea Generation Process
Investing in a large public market with thousands of liquid alternatives requires us to optimize our scarcest resource - time. It is not reasonable, possible, or optimal to "boil the ocean" and develop an opinion on all companies in the market. Why waste time doing a deep dive on something that is obviously not in our wheelhouse or that doesn't meet some of our basic criteria? The stock-picking process must be optimized to reject prospects quickly so we can focus our time and efforts on the best ideas. Thankfully, once we find ones we like, we are free to invest. One of the best features of public markets is that there is no investor exclusivity for great ideas - anyone can own what they believe are the best companies for their criteria.
Idea generation can start in a variety of ways. Let's go through some examples of how investors kickstart the process.
Some investors use a "brute force," disciplined approach to idea generation (e.g. look at one new stock per day, x stocks per week, etc.). Even if they know they will kick out most ideas as they go through the process, they will still build a model, estimate valuation, complete a write-up, etc. to learn about a new company or industry, and to determine valuations/prices at which they would be interested.
Some firms task their teams with breaking down sectors and expect analysts and portfolio managers to have an opinion on most companies within those sectors. They believe their specialists' deep sector expertise will be the primary driver of performance by picking the relative winners and losers.
Some screen for valuation (XYZ stock is cheap) or price moves (52-week highs/lows, large drawdowns or price spikes) to inspire their investigations.
Some look for strong secular trends (e.g. generative AI, electric vehicles, cloud computing, e-commerce, etc.) and then find the best ways to play those trends.
Many investors look for companies trading at attractive valuations and financial ratios with a catalyst that will unlock the hidden value in those companies. They may use quantitative metrics (return on invested capital, return on assets, operating margins, etc.) to screen for "quality" companies.
Many investors look at what other reputable investors have been buying and selling in their 13-Fs, and create interest lists from those changes.
Some follow price momentum, believing the weak will continue to weaken and the strong will get stronger.
These are just a small sample of all the ways investors generate investment ideas. One approach is not better than another - each investor has to figure out what process works for him or her individually. Thankfully, there are infinitely many ways to generate ideas and thousands of companies out there - lots of opportunity and no exclusivity!
Recurve's Stock-Picking Process
We filter out the majority of companies in the market by using some pretty strict high-level criteria, as we have written about in our post about the Builder Company framework. We seek companies that have established themselves as strengthening leaders in healthy markets, that have shown proven and predictable unit economics, that have strong validation from customers in their markets, and that have powerful flywheel effects to their earnings power and their competitive advantages as they increase in scale. Additionally, we seek managers that employ an owner/operator mindset with regard to operating strategy and capital allocation that optimizes for free cash flow per share over time.
Our idea generation process starts with surveying the landscape for proven (but not mature) market-leading companies that have identifiable advantages which are defensible based on our extrapolations of competitive dynamics, usually through large advantages in distribution, physical infrastructure, and/or cost economics (i.e. being the lowest cost producer in the market). Most often, our ability to confidently predict long-term competitive differentiation is what kicks out companies from our research process, even if the near- to medium-term secular trend and/or growth opportunity is attractive. If a company has a solid 2-3 years of runway but a murkier 5- to 10-year outlook, we pass.
Our screening criteria are a necessary but insufficient first filter which then starts the gears on the due diligence process. This process begins with generating a hypothesis on the company's advantages and developing an understanding of what it is building, what it could become in the future, and how its industry's competitive dynamics are evolving. We populate a list of questions that need answering to move forward and then it enters the research funnel, which is a robust, iterative due diligence process to answer all our questions. This process includes building a financial model, talking to the company, its competitors, its suppliers, its customers, its former employees, and more. We read through years of filings, earnings calls, conference presentations, investor days, and more - for the company, for its competitors, for its customers, for its suppliers. We also read non-financial materials - trade publications, books on the company and/or industry, articles on the internet - all with the hope of shaping our understanding of the company, its culture, its management team, and how it is positioned to capture the opportunity in front of it.
Through this process, we try to assess all the risks to the company and think through fundamental scenarios that would materially weaken our conviction in the longer-term outcomes and cause us to sell. Working through the research funnel takes typically takes several weeks to several months on to get to a final "go" decision. The "no go" decision can happen at any juncture, but most often occurs relatively early in the process.
Quantitatively, we spend a lot of time chewing on the unit economics of the business - how it creates its products and services; who its customers are and how they make decisions; how to think about input cost and pricing dynamics and how they evolve over time; and how competitors are positioned relative to the company we are studying. Oftentimes, our companies have significant vertically integrated capabilities which makes them more complicated to analyze, but this is the stage we love - picking apart a business to understand its basic components, so that we have an understanding of the future scalability and earnings power. It feels like solving a puzzle, especially when we find companies that continue to meet our criteria the deeper we go. You can see small snippets of the type of work we do on our Insights page.
Most fundamental investors iterate around similar due diligence workflow, but two independent analysts or teams running the same process on the same company could reach completely different conclusions, depending on their assessments of all the qualitative factors, future financial expectations, valuation, opportunities, risks, and time frames. For better or worse, stock-picking is a game of judgment and weighing probabilities of future outcomes, and investment research is not a process with deterministic outcomes such that due diligence input = predictable performance output every time.
This is what makes stock-picking fun and challenging. Investor A could spend 10 hours on an idea, recognize a key insight, and make amazing returns, while investor B could spend 100 hours on another idea, miss a key insight, and generate terrible losses. Both investors could present a logical and convincing argument for owning their stocks. Sound judgment is needed at every step of the way to efficiently allocate our time when choosing what to work on, to thoroughly conduct research and due diligence, to allocate capital to those ideas, and to manage through the emotions of owning stocks on a long-term basis through periods of significant volatility.
On the last point, we don't discuss in this post all the behavioral considerations of portfolio management and trading that can magnify or nullify winners and losers, but they are every bit as important as the stock-picking process.
Some Thoughts on Valuation
A lot of investors cite valuation as a strong reason to buy or sell a stock (e.g. "Can you believe Apple trades at 30x earnings? It must be a sell!"). We think this is the wrong approach because valuations are highly dependent on the forward outlook of businesses. Ultimately, long-term investors (i.e. not speculators) believe their companies are cheap on metrics and time horizons relevant to their processes. They could be cheap on trailing earnings, on next year's earnings, or on long-term earnings power in the future, but discounted back to present day values. All the variations and differences in preferences make the market a dynamic system which causes significant fluctuations in supply and demand for a companies' stocks, which in turn create volatility in both directions. Large positive or negative dislocations usually occur when near-term speculators move in the same direction as long-term investors.
While we believe all of our investments offer attractive valuations relative to their future free cash flow per share, Recurve never starts with valuation as a reason to buy or sell a stock - for new ideas or for existing portfolio companies. This may sound at odds with a value-oriented investment firm, but philosophically we believe in focusing on the fundamental and qualitative dynamics first, which more strongly predict future growth and earnings outcomes. "Cheap" stocks are often cheap for good reason (challenges to growth and/or margins, or capital structure), just as "expensive" stocks are often expensive for good reason (superior visibility, big opportunities for future earnings growth, etc.). No stock is "cheap" enough if it is insolvent and the equity will be wiped out. An "expensive" stock on trailing earnings can be very cheap if it generates sustained, rapid growth in revenue, margins and free cash flow.
At the portfolio level, there are many layers of nuanced analysis, weighing opportunity cost across companies with dynamically evolving fundamental strength, valuation, and long-term economic opportunity available for each existing position and all new research ideas.
Conclusion
There are many ways to pick stocks, and every investor should do whatever makes the most sense personally, i.e. whatever will allow the investor to behave rationally (in his or her mind) across the wide spectrum of outcomes that can and will occur. Stocks fluctuate significantly over time and the market has a way of testing every investors' conviction and processes over and over again, so it’s important to have a consistent way of making judgments during times of peak strain.
Thankfully, the public equity market allows ample opportunities for all participants to find a subset of stocks that fit what they are seeking. Hopefully this post shed some light on the fun, fascinating, and challenging process of picking stocks.
